FRTB Fundamental Review of the Trading Book Preparation Notes Overview The Fundamental Review of the Trading Book FRTB is a comprehensive set of market risk capital rules developed by the Basel Committee on Banking Supervision BCBS It aims to address deficiencies in the previous market risk framework and enhance the overall financial stability of banks Key Objectives 1 Enhance Risk Sensitivity Improve the measurement of market risks by introducing more risk sensitive methods 2 Boundary Between Trading Book and Banking Book Clearly define and enforce the boundary to prevent regulatory arbitrage 3 Capital Requirements Ensure that capital requirements are more closely aligned with the actual risk exposure Main Components 1 Revised Standardized Approach SA 2 Internal Models Approach IMA 3 Risk Factor Eligibility Test RFET 4 Non Modellable Risk Factors NMRFs 5 P L Attribution Test 6 Trading Book and Banking Book Boundary 7 Liquidity Horizons Detailed Breakdown 1 Revised Standardized Approach SA Sensitivity Based Approach SBA Uses risk sensitivities as inputs to calculate capital requirements Default Risk Charge DRC Accounts for default and credit migration risks Residual Risk Add On RRAO Covers risks not captured by SBA or DRC 2 Internal Models Approach IMA Expected Shortfall ES Replaces Value at Risk VaR as the risk measure Liquidity Adjustments Different liquidity horizons for different risk factors Stress Testing Includes stress scenarios to capture extreme but plausible market conditions 3 Risk Factor Eligibility Test RFET Determines which risk factors can be modeled Requires 12 months of continuous real and verifiable price observations 4 Non Modellable Risk Factors NMRFs Risk factors failing the RFET are considered NMRFs Banks must hold additional capital for NMRFs using a stressed capital add on 5 P L Attribution Test Assesses the accuracy of risk management models by comparing risk theoretical P L with the actual P L 6 Trading Book and Banking Book Boundary Criteria for Classification Clear rules for allocating positions to either the trading or banking book Restrictions on Movement Limits on moving instruments between books to prevent arbitrage 7 Liquidity Horizons Different liquidity horizons for different risk factors to better capture risk over the period it would take to liquidate or hedge a position Implementation Challenges Data Quality and Availability Ensuring high quality data for accurate risk measurement Model Validation Rigorous validation processes for internal models System and Infrastructure Upgrades Enhancing existing systems to handle new requirements Regulatory Compliance Meeting varying requirements from different regulators Benefits Enhanced Risk Management More accurate and sensitive risk measures Financial Stability Stronger capital buffers to absorb losses during market stress Transparency and Comparability Improved clarity in capital requirements and risk measures across banks Steps for Preparation 1 Gap Analysis Identify gaps between current practices and FRTB requirements 2 Data Collection and Management Ensure robust data management systems 3 Model Development and Validation Develop and validate models according to FRTB standards 4 Training and Awareness Educate staff on FRTB requirements and implications 5 Regulatory Reporting Develop systems for accurate and timely reporting to regulators 6 Stress Testing and Scenario Analysis Regularly perform stress tests and scenario analyses to assess capital adequacy Timeline and Milestones Initial Assessment Conduct a comprehensive assessment to understand the scope and impact of FRTB Project Planning Develop a detailed project plan with timelines and milestones Implementation Phase System upgrades model development data collection and training Testing and Validation Rigorously test and validate models and systems Final Preparations Ensure readiness for compliance by the regulatory deadline Conclusion Preparing for FRTB requires significant effort in terms of system upgrades model development data management and staff training By taking a structured approach and addressing the key components and challenges banks can achieve compliance and enhance their overall risk management framework